(Crain’s Chicago Business, 6 February 2006) 

It’s been 33 years since Princeton University economics professor Burton Malkiel advised investors to fill their portfolios with index funds. Over time, he argued in his book “A Random Walk Down Wall Street,” passively managed index funds outperform actively managed mutual funds or stocks. Crain’s asked Mr. Malkiel, 74, why he’s still convinced that’s the way to go.

The message of your book can be summarized as, “You can’t beat the market average, so invest in index funds.” Is there more to your investment philosophy than that?
One ought to either invest entirely in index funds or, at the very least, the core of one’s portfolio should be in index funds. But I have some actively managed funds. I even own a few individual securities. If you think a particular stock is a great buy, then buy it. You can do it with a lot less risk if the core of the portfolio is indexed. And don’t just have stocks, but have some bonds and some money in real estate investment trusts. And your stocks shouldn’t just be domestic. The major growth in the world over the next decade or two will not be in the United States or Europe. It will be in places like China and India and some Latin American countries.

So, the fact that the S&P 500 index was relatively flat this past year shouldn’t deter investors from buying index funds?
The reason the S&P has been doing a little worse, particularly over the last five years, is that smaller companies have been performing better than the huge, big-cap companies. And that’s why the S&P, which is a big-cap index, has been underperforming broader indexes such as the Dow Wilshire 5000. Indexing, for me, is not just buying the S&P, but buying the total stock market. Of course, even the broad-index investor is going to lose money when the stock market goes down. But you don’t lose your shirt.

Why can’t fund managers beat the indexes?
Markets are pretty efficient over the long haul, and the active manager charges a big fee. You can now buy index funds with an expense ratio of 10 basis points or less, meaning the management fee is one-tenth of 1% or less. The active managers charge about 1.5%.

How do you explain, then, stock-picking stars like Warren Buffett?
If I had known 30 years ago when I first wrote my book that Warren Buffett was going to be Warren Buffett, I wouldn’t have given the advice to go buy index funds. I would have said go buy Berkshire Hathaway. You know what? There will be three or four Warren Buffetts over the next 30 years, but you don’t know who they are, and I don’t know who they are. It’s not that they don’t exist, but they are impossible to identify in advance.

Index funds are supposed to match the return of the index they are following. Are there any times when this does not occur?
Not if the index manager is doing what he or she is supposed to. There are things that are called enhanced index funds, where the manager tries to do a little better. But on a pure index fund, you get the index. There are a few index funds that charge very high expense ratios, over 1%, and they will underperform the index.

Does it matter which fund provider you go with?
Look for low cost. Basically, if you’re going to be in a fund, it means going to people like Fidelity Investments or the Vanguard Group. Vanguard has the largest selection, because they got into indexing first.

©2006 by Crain Communications Inc.